Waiting for Japan's election: Could the 'Abe trade' be justified?

Story highlights

Former PM Shinzo Abe is campaigning on joint monetary and fiscal stimulus to end persistent deflation

Abe has threatened legislative action if the Central Bank of Japan doesn't commit to a 2% inflation target

Given political constraints, Abe is unlikely to secure the working majorities needed to pass such legislation, Scicluna writes

Hopes that this weekend's Japanese election will deliver a major policy shift towards delivering higher growth and inflation have given the country's financial markets a long-overdue shot in the arm.

Stock markets have rallied, up 10% on the month to their highest levels since April.

The yen, which was recently within touching distance of its post-war high, causing agony for Japan's manufacturers, has eased to eight-month lows. And Japan's long-term interest rates have fallen to their lowest levels since 2003.

Optimism hangs on the electoral rhetoric of LDP leader Shinzo Abe, odds-on to be Japan's next prime minister.

Exasperated by Japan's two lost decades and persistent deflation, Abe has demanded aggressive action from Japan's central bank, calling for it to generate 2% inflation and do whatever necessary -- including buying an "unlimited" amount of government bonds -- to hit that target.

And harking back to days gone by, Abe has called for new budgetary stimulus too, including extra public works spending. But could an Abe-led government really snap Japan out of its seemingly interminable economic malaise?

Of course, campaigning and governing are two very different things.

And, given the perilous state of Japan's public finances, the next government will have precious little room for maneuver to boost public investment.

Indeed, it will have countless unpalatable budgetary decisions to make, not least making the social security system affordable given Japan's rapidly aging population. So, in practice, fiscal policy is unlikely to be able to provide meaningful stimulus over the term of the next government.

That means that the onus will be on monetary policy to boost growth and inflation. Following rebuttals from present Bank of Japan Governor Shirakawa, Abe recently toned down his attacks on the central bank.

But the LDP manifesto maintained Abe's commitment to a 2% inflation target, with legislative action to be considered to force the Bank of Japan's hand if it does not co-operate.

Of course, whether an LDP-led government can amend laws related to the central bank, or will in large part depend on the election outcome.

But even if Abe secures a comfortable majority in the Lower House, given its lack of control of the Upper House, it might struggle to secure the working majorities it will need in the Diet to pass legislation comfortably.

Certainly, a government reliant on a number of parties to pass legislation may mean that complicated reforms to shake up the Bank of Japan are likely to remain more of a threat than a reality.